Tag Archives: intangible write downs

Broken Record II

As the S&P500 hit an intraday all-time high yesterday, it’s been nearly 9 months since I posted on the valuation of the S&P500 (here). Since then, I have touched on factors like the reversal of global QE flows by Central Banks (here) and the lax credit terms that may be exposed by tightening monetary conditions (here). Although the traditional pull back after labor day in the US hasn’t been a big feature in recent years, the market feels frothy and a pullback seems plausible. The TINA (There Is No Alternative) trade is looking distinctly tired as the bull market approaches the 3,500-day mark. So now is an opportune time to review some of the arguments on valuations.

Fortune magazine recently had an interesting summary piece on the mounting headwinds in the US which indicate that “the current economic expansion is much nearer its end than its beginning”. Higher interest rates and the uncertainty from the ongoing Trump trade squabble are obvious headwinds that have caused nervous investors to moderate slightly valuation multiples from late last year. The Fortune article points to factors like low unemployment rates and restrictions on immigration pushing up wage costs, rising oil prices, the fleeting nature of Trump’s tax cuts against the long-term impact on federal debt, high corporate debt levels (with debt to EBITDA levels at 15 years high) and the over-optimistic earnings growth estimated by analysts.

That last point may seem harsh given the 24% and 10% growth in reported quarterly EPS and revenue respectively in Q2 2018 over Q2 2017, according to Factset as at 10/08/2018. The graph below shows the quarterly reported growth projections by analysts, as per S&P Dow Jones Indices, with a fall off in quarterly growth in 2019 from the mid-20’s down to a 10-15% range, as items like the tax cuts wash out. Clearly 10-15% earnings growth in 2019 is still assuming strong earnings and has some commentators questioning whether analysts are being too optimistic given the potential headwinds outlined above.

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According to Factset as at 10/08/2018, the 12-month forward PE of 16.6 is around the 5-year average level and 15% above the 10-year average, as below. As at the S&P500 high on 21/08/2018, the 12-month forward PE is 16.8.

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In terms of the Shiller PE or the cyclically adjusted PE (PE10), the graph below shows that the current PE10 ratio of 32.65 as at the S&P500 high on 21/08/2018, which is 63% higher than 50-year average of 20. For the purists, the current PE10 is 89% above the 100-year average.

click to enlargeCAPE Shiller PE PE10 as at 21082018 S&P500 high

According to this very interesting research paper called King of the Mountain, the PE10 metric varies across different macro-economic conditions, specifically the level of real interest rates and inflation. The authors further claim that PE10 becomes a statistically significant and economically meaningful predictor of shorter-term returns under the assumption that PE10 levels mean-revert toward the levels suggested by prevailing macroeconomic conditions rather than toward long-term averages. The graph below shows the results from the research for different real yield and inflation levels, the so-called valuation mountain.

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At a real yield around 1% and inflation around 2%, the research suggests a median PE around 20 is reasonable. Although I know that median is not the same as mean, the 20 figure is consistent with the 50-year PE10 average. The debates on CAPE/PE10 as a valuation metric have been extensively aired in this blog (here and here are examples) and range around the use of historically applicable earnings data, adjustments around changes in accounting methodology (such as FAS 142/144 on intangible write downs), relevant time periods to reflect structural changes in the economy, changes in dividend pay-out ratios, the increased contribution of foreign earnings in US firms, and the reduced contribution of labour costs (due to low real wage inflation).

One hotly debated issue around CAPE/PE10 is the impact of the changing profit margin levels. One conservative adjustment to PE10 for changes in profit margins is the John Hussman adjusted CAPE/PE10, as below, which attempts to normalise profit margins in the metric. This metric indicates that the current market is at an all time high, above the 1920s and internet bubbles (it sure doesn’t feel like that!!). In Hussman’s most recent market commentary, he states that “we project market losses over the completion of this cycle on the order of -64% for the S&P 500 Index”.

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Given the technological changes in business models and structures across economic systems, I believe that assuming current profit margins “normalise” to the average is too conservative, particularly given the potential for AI and digital transformation to cut costs across a range of business models over the medium term. Based upon my crude adjustment to the PE10 for 2010 and prior, as outlined in the previous Broken Record post (i.e. adjusted to 8.5%), using US corporate profits as a % of US GDP as a proxy for profit margins, the current PE10 of 32.65 is 21% above my profit margin adjusted 50-year average of 27, as shown below.

click to enlargeCAPE Shiller PE PE10 adjusted as at 21082018 S&P500 high

So, in summary, the different ranges of overvaluation for the S&P500 at its current high are from 15% to 60%. If the 2019 estimates of 10-15% quarterly EPS growth start to look optimistic, whether through deepening trade tensions or tighter monetary policy, I could see a 10% to 15% pullback. If economic headwinds, as above, start to get serious and the prospect of a recession gets real (although these things normally come quickly as a surprise), then something more serious could be possible.

On the flipside, I struggle to see where significant upside can come from in terms of getting earnings growth in 2019 past the 10-15% range. A breakthrough in trade tensions may be possible although unlikely before the mid-term elections. All in all, the best it looks like to me in the short term is the S&P500 going sideways from here, absent a post-labor day spurt of profit taking.

But hey, my record on calling the end to this bull market has been consistently broken….

Broken Record

Whilst the equity market marches on regardless, hitting highs again today, writing about the never-ending debates over equity valuations makes one feel like a broken record at times. At its current value, I estimate the S&P500 has returned an annualised rate of nearly 11%, excluding dividends, since its low in March 2009. As of the end of September 2017, First Trust estimated the total return from the S&P500 at 18% since March 2009, as per the graph below.

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Goldman Sachs recently published an analysis on a portfolio of 60% in the S&P 500 and 40% in 10-year U.S. Treasuries, as per the graph below, and commented that “we are nearing the longest bull market for balanced equity/bond portfolios in over a century, boosted by a Goldilocks backdrop of strong growth without inflation”. They further stated that “it has seldom been the case that all assets are expensive at the same time—historical examples include the Roaring ‘20s and Golden ‘50s. While in the near term, growth might stay strong and valuations could pick up further, they should become a speed limit for returns”.

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My most recent post on the topic of US equity valuations in May looked at the bull and bear arguments on low interest rates and heighten profit margins by Jeremy Grantham and John Hussman. In that post I further highlighted some of the other factors which are part of the valuation debate such as the elevated corporate leverage levels, reduced capital expenditures, and increased financial risk taking as outlined in the April IMF Global Financial Stability report. I also highlighted, in my view, another influential factor related to aging populations, namely the higher level of risk assets in public pensions as the number of retired members increases.

In other posts, such as this one on the cyclically adjusted PE (CAPE or PE10), I have highlighted the debates around the use of historically applicable earnings data in the use of valuation metrics. Adjustments around changes in accounting methodology (such as FAS 142/144 on intangible write downs), relevant time periods to reflect structural changes in the economy, changes in dividend pay-out ratios, the increased contribution of foreign earnings in US firms, and the reduced contribution of labour costs (due to low real wage inflation) are just some examples of items to consider.

The FT’s John Authers provided an update in June on the debate between Robert Shiller and Jeremy Siegel over CAPE from a CFA conference earlier this year. Jeremy Siegel articulated his critique of the Shiller CAPE in this piece last year. In an article by Robert Shiller in September article, called “The coming bear market?”, he concluded that “the US stock market today looks a lot like it did at the peaks before most of the country’s 13 previous bear markets”.

The contribution of technology firms to the bull market, particularly the so-called FANG or FAANG stocks, has also been a much-debated issue of late. The graph below shows the historical sector breakdown of the S&P500 since 1995.

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A recent article from GMO called “FAANG SCHMAANG: Don’t Blame the Over-valuation of the S&P Solely on Information Technology” tried to quantify the impact that the shift in sector composition upon valuations and concluded that “today’s higher S&P 500 weight in the relatively expensive Information Technology sector is cause for some of its expensiveness, but it does not explain away the bulk of its high absolute and relative valuation level. No matter how you cut it, the S&P 500 (and most other markets for that matter) is expensive”. The graph below shows that they estimate the over-valuation of the S&P500, as at the end of September 2017, using their PE10 measure is only reduced from 46% to 39% if re-balanced to take account of today’s sector weightings.

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In his recent article this month, John Hussman (who meekly referred to “his incorrectly tagged reputation as a permabear”!!) stated that “there’s no need to take a hard-negative outlook here, but don’t allow impatience, fear of missing out, or the illusion of permanently rising stock prices to entice you into entrusting your financial future to the single most overvalued market extreme in history”.

As discussed in my May post, Hussman reiterated his counter-argument to Jeremy Grantham’s argument that structurally low interest rates, in the recent past and in the medium term, can justify a “this time it’s different” case. Hussman again states that “the extreme level of valuations cannot, in fact, be “justified” on the basis of depressed interest rates” and that “lower interest rates only justify higher valuations if the stream of future cash flows is held constant” and that “one of the reasons why reliable valuation measures have retained such a high correlation with subsequent market returns across history, regardless of the level of interest rates, is that the impact of interest rates and growth rates on “terminal” valuations systematically offset each other”.

Hussman also again counters the argument that higher profit margins are the new normal, stating that “it’s important to recognize just how dependent elevated profit margins are on maintaining permanently depressed wages and salaries, as a share of GDP” and that “simply put, elevated corporate profit margins are the precise mirror-image of depressed labour compensation” which he contends is unlikely to last in a low unemployment environment.

Hussman presents a profit margin adjusted CAPE as of the 3rd of November, reproduced below, which he contends shows that “market valuations are now more extreme than at any point in history, including the 1929 and 2000 market highs”.

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However, I think that his profit margin analysis is harsh. If you adjust historical earnings upwards for newer higher margin levels, of course the historical earning multiples will be lower. I got to thinking about what current valuations would look like against the past if higher historical profit margins, and therefore earnings, had resulted in higher multiples. Using data from Shiller’s website, the graph below does present a striking representation of the relationship between corporate profits (accepting the weaknesses in using profits as a percentage of US GDP) and interest rates.

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Purely as a thought experiment, I played with Shiller’s data, updating the reported earnings for estimates through 2018 (with a small discount to reflect over-zealous estimates as per recent trends of earnings revisions), recent consensus end 2018 S&P500 targets, and consensus inflation and the 10-year US interest rates through 2018. Basically, I tried to represent the base case from current commentators of slowly increasing inflation and interest rates over the short term, with 2018 reported EPS growth of 8% and the S&P500 growing to 2,900 by year end 2018. I then calculated the valuation metrics PE10, the regular PE (using trailing twelve month reported earnings called PE ttm), and the future PE (using forward twelve month reported earnings called PE ftm) to the end of 2018. I further adjusted the earnings multiples, for 2007 and prior, by applying an (principally upward) adjustment equal to a ratio of the pre-2007 actual  corporate profits percentage to GDP divided by a newly assumed normalised percentage of 8.5% (lower than the past 10-year average around 9% to factor in some upward wage pressures over the medium term). The resulting historical multiples and averages are shown below.

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Based upon this analysis, whilst accepting its deeply flawed assumptions, if 2018 follows the base case currently expected (i.e. no external shocks, no big inflation or interest rates moves, steady if not spectacular earnings growth), the S&P500 currently looks over-valued by 50% to 20% using historical norms. If this time it is different and higher profit margins and lower interest rates are the new normal, then the S&P500 looks roughly fairly-valued and current targets for 2018 around 2,900 look achievable. Mind you, it’s a huge leap in mind-set to assume that the long-term average PE is justifiably in the mid-20s.

I continue to be concerned about increasing corporate leverage levels, as highlighted in my May post from the IMF Global Financial Stability report in April, and the unforeseen consequences of rising interest rate after such a long period of abnormally low rates.

In the interim, to paraphrase an ex-President, it’s all about the earnings stupid!

Carry on CAPE

The debates on the cyclically adjusted PE (CAPE), developed by recent Nobel Prize winner Robert Shiller, as a market valuation indicator continue to rage. My last post on the subject is indicative of where I left the arguments.

A variation on Jeremy Siegel’s arguments against CAPE was put forward in an interesting post on the blog Philosophical Economics (hereinafter referred to as PE), centred on the failure of CAPE to mean revert through the ups and downs of the past 23 years and the need for a consistent measure for earnings in the PE calculation across historical reference periods.

The first point essentially relates to the time period over which CAPE is relevant for today’s global economy. Shiller uses available S&P reported GAAP earnings dating back to the 1936 and has supplemented them with his own GAAP earnings calculations from 1936 back to 1871. PE makes the point that historical periods which are “distorted by world wars (1914-1918, 1939-1945, 1950-1953), gross economic mismanagement (1929-1938), and painfully high inflation and interest rates (1970-1982)” may not be the most appropriate as a reference period for today (as reflective of the changed macro-economic period covering the so called great moderation). In essence, PE is saying that structural changes in the economy and investor sophistication may justify a shorter and more relevant time period (yes, PE admits it is a flavour of the “this time it’s different” argument!).

On earnings, PE repeats many of Siegel’s arguments. For example, the point is again made about asymmetric accounting changes to intangible write downs from FAS 142/144. In addition, PE also highlights the lower dividend payouts of 34% over the past 18 years compared to 52% over the 40 year period between the mid-50s and mid-90s. PE argues that lower dividend yields indicate higher investment by firms and therefore support the argument that historical comparisons may not be as relevant.

PE uses Pro-Forma (non-GAAP) S&P earnings from 1954 as reported by Bloomberg for earnings (as opposed to Siegel’s use of National Income and Product Accounts (NIPA) earnings for all approx 9,000 US corporations) and stresses that these earnings may not necessarily be more applicable but they are at least consistent. PE shows that using these earnings since 1954 the market (as at December 2013) was only modestly above the geometric mean and further supports the use of Pro-Forma earnings by back testing this metric against CAPE as an indicator of value through the financial crisis.

A counter-argument (in a December paper) from Bill Hester of Hussman Funds centred on differences in the Bloomberg Pro-Forma earnings used in PE’s calculations, arguing that from 1988 to 1998 the earnings reported by Bloomberg are a mixture of reported & operating earnings and that from 1998 they are akin to operating earnings. The argument highlights the problem of data quality in many databases which are commonly used in the market creating a source of systematic risk. [As an aside, on an individual stock basis, I have found issues with data from commonly used databases and that is why I always take my historical figures from published accounts – not that they are without any issues, just try reconciling some of AIG’s historical financial statements given the almost annual restatements!]. On earnings, Hestor uses work done by Andrew Smithers in his book “The Road to Recovery” which suggests that executive compensation tied to short term results has been a factor in earnings volatility.

PE counters Hester’s counter argument in another post that after adjusting the Boomberg data pre-1998 and applying an adjustment for the change in dividend payout ratio the ProForma earnings based CAPE still signals a less overvalued market that Shiller’s CAPE. PE also rubbishes the contention from Smithers that volatility is as a result of executive remuneration saying that low volatility is in the executive’s interest to maximise their options which vest over time and that investment is currently low due to the uncertainty around unprecedented macro- economic risks.

PE cites arguments similar to those of other bulls such as Siegel who content that US corporate profits as a percentage of GDP (or GNP) is high compared to historical levels due to increased foreign contributions to profits, lower corporate taxes and a higher S&P concentration of globalised technology and energy firms with fatter profit margins. PE points to stability in statistics such as S&P 500 net profit margins for non-financials (excluding energy & technology) produced by BoA Merrill Lynch and analysis of David Bianco from Deutsche Bank on firms with a high level of foreign sales showing higher profit margins (see graph reproduced below). To be fair to Bianco, he recently maintained his year-end 2014 S&P500 target of 1850 and warning of volatility in 2014 stating “buy the dips, but I’m also saying in advance, wait for the dips“.

click to enlargeDeutsche Bank Foreign vrs Domestic Profit MarginsIn a December note, the extremely bearish John Hussman stated that “in recent years, weak employment paired with massive government deficits have introduced a wedge into the circular flow, allowing wages and salaries to fall to the lowest share of GDP in history, even while households have been able to maintain consumption as the result of deficit spending, reduced household savings, unemployment compensation and the like”. In another note from John Hussman out this week on foreign profits, based upon a range of valuation metrics (see graph reproduced below) he puts the S&P500 at a 100% premium to the level needed to achieve historical normal returns (or indicating a negative total return on horizons of 7 years or less). He also rubbishes the higher contribution from foreign profits, saying they have been decreasing since 2007 and that they “do not have any material role in the surge in overall profit margins”.

click to enlargeHussman S&P500 Valuation March 2014The (only) slightly more cheerful folk over at GMO also had an insightful paper out in February by James Montier on the CAPE debate. One of the more interesting pieces of analysis in the paper was a Kalecki decomposition of profits which indicate that the US government deficit is a major factor in replacing reduced investment since the crisis (see graph reproduced below). As we know, this US deficit is in the process of being run down and the knock on impact upon profits could result (save a recovery in investment or a significant re-leveraging of households!). The Kalecki composition also seems to support the larger contributions from foreign earnings (albeit a decreasing contribution in recent years).

click to enlargeGMO Kalecki DecompositionDepending upon whether you use the S&P500 PE, the Shiller PE or the NIPA based PE since 1940 the market, according to Montier, is 30%, 40% or 20% overvalued respectively.  Using a variety of metrics, Montier estimates that the expected total return (i.e. including dividends) for the market over the next 7 years ranges from an annual return of 3.6% from Siegel’s preferred method using NIPA to a negative 3.2% per annum from a full revision Shiller PE (using 10 year trend earnings rather than current trailing 10 year earnings).  The average across a number of valuation metrics suggests a 0% per annum return over the next 7 years!

Ben Inker also has a piece in the February GMO letter on their strategy of slowly averaging in and out of the market. Inker calls it slicing whereby you take account of historical forecasts as well as your current “spot” view of valuations. Their research shows that you capture more value through averaging purchasing or selling over time by benefiting from market momentum. GMO currently are in selling mode whereby they “are in the process of selling our equity weight down slowly over the next 9 to 12 months”.

So, where do all of these arguments leave a poor little amateur investor like me? Most sensible metrics point to the S&P500 being overvalued and the only issue is quantum. As I see it, there is validity on both sides of the CAPE arguments outlined above. Earnings are high and are likely to be under pressure, or at best stable, in the medium term. I am amenable to some of the arguments over the relevant timeframe used to calculate the mean to assess the mean reverting adjustment needed (I do however remain wedded to mean revision as a concept).

To me, the figures of 20% to 40% overvaluation in Montier’s note based on calculations back to 1940 from different CAPE calculations feel about right. A 30% overvaluation represents the current S&P500 to a mean calculated from 1960. The rapid bounce back in the S&P500 from the 5% January fall does show how resilient the market is however and how embedded the “buy on the dip” mentality currently is. GMO’s philosophy of averaging in and out of the market over time to take advantage of market momentum makes sense.

In the absence of any external shock that could hit values meaningfully (i.e. +15% fall), the market does look range bound around +/- 5%. Common sense data points such as the Facebook deal for WhatsApp at 19 times revenues confirm my unease and medium term negative bias. I have cut back to my core holdings and, where possible, bought protect against big pull backs. In the interim, my wish-list of “good firms/pity about the price” continues to grow.

They say that “the secret to patience is doing something else in the meantime”. Reading arguments and counter argument on CAPE is one way to pass some of the time…….